But That's Not What Ships Were Made For: Thoughts and fundamental analysis

10/03/2011

Activision Blizzard is an IP powerhouse unrivaled in the markets it dominates. New titles in the Call of Duty franchise set sales records annually, and secondary revenue sources such as additional content and premium subscription services are boosting RoIC and sustaining revenue well beyond a single holiday season. Every game published by Blizzard is a category killer. World of Warcraft has almost four times more players than the next most popular massively multiplayer online game, and it’s seven years old. Monthly subscriptions provide a steady stream of revenue, bolstered by expansion packs published sporadically. International professional video game leagues have chosen Starcraft as their strategy game of choice for over a decade, and new entrants seem to pose little threat. Starcraft is the 21st century’s chess.

Surprisingly for such a mature business, low-hanging fruit exists to boost sales and margins. The most notable opportunities in this space include “free-to-play” versions of older titles in the Call of Duty series for release in China and other countries with lower GDP per capita. Very low-quality titles in the first person shooter space have demonstrated that this model can be profitable, and Call of Duty titles could easily dominate with a minimal investment in development and marketing. The Blizzard IP extends well beyond just video games. Characters in the Warcraft, Starcraft, and Diablo series have intricate stories and world lore that has been developed over the past two decades through video games, books, board games, and trading card games. The obvious next step is to bring these stories to the silver screen. Development of the first Warcraft movie has been in process for years now, and its success could lead to endless sequels plus development of the Starcraft and Diablo series. On a three-year rotation, (assuming Blizard’s next MMO builds off one of these existing three franchises), the characters and stories can stay fresh. The synergistic effects of marketing and releasing such movies is impossible to predict, but can only have a positive impact on game and merchandise sales.

In the LTM, excluding non-cash impairment charges (I’m not taking out stock-comp), ATVI earned just over $1 billion of net income, or $0.84 per share. However, the release of Starcraft in the LTM inflates revenue and earnings from what we could expect to be a normal run rate, by about $0.20 per share. At $11 per share, this is a trailing multiple of 13.0x (or 17.2x excluding Starcraft). In 2010 and 2009, ATVI repurchased $959 and $1,109 million of stock respectively, over 80% of cash flow from operations. Management was able to do this without throttling growth partly because working capital reductions have contributed meaningfully to operating cash flow. The key contributors have been reductions in AR and inventory caused by a transition from selling boxes through retailers to making games available online for download. This was made clear in a recent investor presentation:

The real risk to the investment thesis is declining revenue from Warcraft. While Activision accounted for 56% of revenue in the LTM, Blizzard accounted for 57% of operating income. In 2010, Warcraft accounted for 89% of Blizzard revenue. So obviously ATVI is extremely dependent on the continued profitability of this one game… which is probably in terminal decline. Modeling the effects of this decline is extremely important. Fortunately, the next Blizzard MMO has been in development for years and could be ready as early as 2013. Even if Titan is launched a year or two late, its official announcement will free analysts to start building Titan revenue into models.

Call of Duty

Activision’s most notable IP is the Call of Duty franchise. CoD dominates the first person shooter market segment, selling twice as many copies as Halo, the next best-seller. This is mostly ecause CoD is available on Xbox, PS3, and PC, whereas Halo is an Xbox exclusive, but CoD outsold Halo even on the Xbox alone. In 2010, CoD was responsible for 31% of ATVI revenue.

Development responsibilities are shared between two companies, Infinity Ward and Treyarch, each with a two-year product cycle resulting in one new game for every holiday season. Ignoring the obvious economic advantages of this arrangement (milking the IP twice as fast), from a risk-diversification point of view, the decision to have two studios work on the project was fortuitous.

Infinity Ward had historically been considered the better of the two development studios, with higher sales for the Modern Warfare spinoffs and better ratings. Treyarch continued to produce games in a WWII setting until Black Ops in the cold war. Immediately following the release of Modern Warfare 2, the executive management of Infinity Ward was fired in a move that shocked the industry. Jason West and Vince Zampella quickly filed suit against Activision demanding back compensation that was withheld. The first sentence of the complaint accuses Activision of “astonishing arrogance” with the second sentence bragging that “Jason West and Vince Zampella are among the most talented and successful videogame developers in the world”. The suit claimed $36 million in damages, although additional claims have since been added.

Activision responded with a complaint of its own, accusing West, Zampella, and Electronic Arts of having “secret meetings” with the intention to “derail Activision’s Call of Duty franchise, disrupt its Infinity Ward development studio, and inflict serious harm on the company”. The suit seeks $400 million in damages and puts forth a strong case that West and Zampella were fired for good cause.

The upside of a win outweighs the downside of a loss, but the most important factor has nothing to do with the lawsuit. Call of Duty Black Ops, the most successful game in the CoD franchise, was produced by Treyarch. Treyarch proved it could produce a competitive offering, and just in time for Infinity Ward to disintegrate:

Despite the problems, the next installment in the CoD Modern Warfare series should be out in time for the 2011 holiday season. It’s been developed collaboratively by a reformed Infinity Ward, a new studio named Sledgehammer, and the Activision internal development team Raven. It’s hard to guess what the ratings (or more importantly the sales) will be, but with the installed base of Xbox and PS3 units rising by an estimated 20%, sales should grow commensurately.

If preorders are any indication, Modern Warfare 3 should easily surpass Black Ops. These charts from vgchartz.com show preorders for both CoD franchises with 13 weeks remaining till launch:

The charts show Black Ops had 504,027 console pre-orders in 2010 (13 weeks out), compared to 1,099,457 for the upcoming CoD title. This also shows that CoD has a healthy lead over Battlefield 3, Electronic Art’s contender praised for a revolutionary graphics engine and destructible environments (two weeks closer to launch). The question then becomes: are pre-orders a good proxy for future sales? This chart compares NA pre-orders for the top games published within the last few years and NA first week sales:

It seems like pre-orders have generally been around half of first week sales and it seems like pre-orders are a decent guide to future sales. Unless the sales multiple decreases significantly from where it’s been historically, CoD is on target to significantly increase sales this year. However, it’s bumping up against the limits of what we could expect sales to be given normal PS3/Xbox attach rates in the 30% range. Normal attach rates would yield 20% growth, in line with installed base growth. For sales to double with a 20% higher installed base, we would need the attach rate to increase to 50%, not a likely scenario. But if the installed base grows by 20% and the attach rate grows from 30% to 35%, unit sales increase 40%, enough to meet my high-end growth estimate for Activision without any help from Activision’s other titles.

The CoD series could also benefit from the re-release of older games in a Free-to-Play format in China and elsewhere. At the moment, a game called Cross Fire is dominating the market, generating revenue in the $1.2 billion range (an estimate I don’t necessarily believe). I haven’t played Cross Fire, and I don’t know if there’s some compelling reason to like it, but the graphics are obviously terrible. Re-releasing an old game to compete with Cross Fire is a move Electronic Arts already made this spring. Activision might have more trouble breaking in now, but it may also be preparing a more compelling offering. At the very least, the move by EA should give some insight into the market opportunity. I haven’t explicitly factored this into my model in any way, the F2P market is pure upside.

Warcraft

Blizzard Entertainment is arguably the most respected game developer in the world. If Blizzard published the next installment in the My Little Pony videogame series, half of the 14 to 25 year-old males in the US with a computer would go out and buy a copy. 1% of them would camp out in tents in front of stores and paint their faces pink with sparkles to pick up their pre-orders. Blizzard games are a must have for gamers.

I linked to this chart above, but I’m reproducing it here as well for full effect with my annotations:

This chart shows how much WoW has dominated the massively multiplayer online (MMO) market and how long it’s held that dominant position. Obviously dozens of other games not represented on this chart are competing for a piece of the MMO pie, but none of these have yet surpassed 1 million subscribers (at least not according to MMOData.net).

But the chart above also shows that Warcraft is probably in decline with little chance of being saved by expansion packs or additional content upgrades. It’s tough to guess what the rate of decline will be, but we can model out some rough scenarios. A base-case scenario is presented below, which I think errs on the conservative side.

The non-GAAP financials provided by ATVI ignore revenue deferment and separate out Blizzard, Activision, and distribution revenue. While my preference is for GAAP, these numbers reveal some interesting information about Blizzards product cycle. Ignoring deferments, Blizzard revenue has looked like this for the past 12 quarters:

In a normal quarter, Warcraft generates about $300 million of revenue and $150 of operating income. Subtracting this out, we can figure that Starcraft generated $451 of revenue and $237 of operating income in its first two quarters. Likewise, the last Warcraft expansion pack yielded $177 million of revenue and $107 of operating income.

My model is driven by a few simple assumptions. I assume that Warcraft will generate $300 million of revenue per quarter, which declines at some rate over the coming five years. I also assume that margins decrease proportionate to revenue declines. As Warcraft subscriptions decline, not only will infrastructure be supported by a smaller player base, but other Blizzard games will become a bigger piece of the pie, indicating that margins will slowly move to be more inline with margins at Activision. I assume margins decline at 1/5 the growth rate, so a 15% decline in Warcraft translates into 3% margin compression. This assumption is arbitrary, but intuitively it looks fair.

On top of this, I add $450 million of revenue from Diablo in 2012, $240 from Warcraft expansions in 2012 and 2014, and then five $25 million payments through 2014 for various Diablo and Starcraft expansions. The timing of these cash flows are based on a leaked production schedule included below, which has so far proven to be fairly reliable:

The excerpt below does not include any revenue from a Warcraft movie or Titan, the next gen MMO. At a 15% decline rate, which I believe is sufficiently pessimistic, my model looks like this:

The purpose of this exercise is really to get comfortable with the four years of declining Warcraft revenues investors might face until Titan. Ignoring all other growth opportunities and the benefits to Activision’s diligent share repurchase program (repurchasing on average 1.5% of the shares outstanding every quarter since 1Q09), the model above estimates a 44% operating income decline from the LTM to 2015. This leaves Warcraft with only 5.3 million subscribers in 2015, still the most popular MMORPG by today’s standards.

As pessimistic as I think I’m being in the model above, there are reasons to be optimistic that Warcraft revenue won’t decline (or decline less). I’m generally not a huge fan of the China growth story, but Warcraft, which is over six years old in the US, is newer in other markets such as China, and its about a year old in Russia. Warcraft has also recently been translated into Portuguese for release in Brazil, another move that can sustain the franchise for another few years. The international appeal of Warcraft should help offset declines in the US, and a movie could revitalize the franchise as well.

Titan

The release of Titan, Blizzard’s next MMO, was originally scheduled for 4Q13. A recent interview with Blizzard’s COO indicates that a working version is already running, implying that the game might actually be ready within a year of its original projected release date. Titan developers have also said that they expect Titan and WoW to be able to coexist in the market simultaneously. The sell-side reports I’ve read are not factoring Titan revenue into their models yet. Any new visibility into Titan should increase analyst estimates for 2014 and beyond. I’ve included some Titan revenue in my finished model, with $384 million in 2014 and $768 in 2015. This is the revenue I would expect to see if Titan attracted 4 and 8 million subscribers respectively at the same at the same per month fees that Warcraft players pay. This would make Titan as popular one year after introduction as Aion, an MMORPG produced by the respected Korean studio NCsoft. At a 7% decline rate, this still leaves Blizzard generating less revenue in 2015 than was earned in 2010, so it seems fair.

Bungie

The CoD franchise’s strongest competitor was Halo, developed at the studio Bungie. After the release of Halo Reach in 2010, Bungie parted ways with Microsoft. Further development of the franchise is left to Microsoft’s in-house studio 343 Industries, established in 2007 specifically to carry the torch. Bungie now has a 10-year distribution agreement with Activision in which Bungie retains ownership of its new IP and Activision has exclusive global distribution rights. With Halo under the stewardship of a new design team, it’s difficult to guess how competitive it will be in future years. It will probably sell extremely well, but a lot is riding on their first installment, and that’s not due out till next year.

While no release dates are set for Bungie to produce its first new IP, the Bungie brand name is well known and any game they produce will be given the attention other similar games might not receive. I believe the distribution rights are valuable, although with no insight into what Bungie is producing, or more importantly, when it might be released, it’s impossible to guess what that value might be. Again, I assume no benefit to the “distribution” revenue line, but upside opportunity exists.

Brand Durability

Video games aren’t as subject to fad risk as some investors might think. The top selling franchises have been around for decades, with Call of Duty earning the first spot on Wikipedia’s list for a game created within the last decade. Many games toping this list are more than 20 years old, demonstrating the staying power of established brand names.

Guitar Hero (distributed by Activision) and Rock Band (distributed by Electronic Arts) are notable recent notable failures. Despite the ubiquity of the games, rumors spread that the original game developer of both series, Harmonix, was sold for $49.99… dollars, not millions. The acquirer assumed around $200 million of liabilities. This was the result of a meltdown, not just for a franchise, but for a genre. Financially, the impact to ATVI was significant, including not only lost sales, but millions in asset impairments and write-downs. The loss of this genre has been a drag, contributing to the flat revenue for ATVI and losses for EA.

Part of the blame for this collapse was levied on Activision for “milking” the brand, an accusation that I believe was warranted to some degree. That being said, as an investor, the business decision was sound. Perceiving the demise of the genre, Activision published 7 Hero titles for platforms (not including iPhone or handheld) in 2009, compared to four in 2008, two in 2007, and two in 2010. According to the 2008 annual report, one of Activision’s titles was the first to ever to generate $1 billion of sales (as a single title). Milking the brand on its way out probably recovered as much revenue as possible, and destroying the genre ruined EA’s chances of a big hit with Rock Band III, which was a legitimately innovative offering. While Activision hasn’t published any titles this year, management has indicated that a design team is still working on the next installment.

I suspect that the loss of this genre has been doubly negative to ATVI. The drag on revenue growth and earnings was the first hit, but also the realization that profitable franchises can disappear has spooked investors. But CoD and Warcraft don’t share much in common with Guitar Hero, in particular the associated hardware requirements and the music licensing fees.

Skylanders

Management is excited about a new Spyro game called “Skylanders”, which uses toys to store game data and access in-game characters. Parents buy a game that comes with a few characters, and then kids beg their parents to buy the rest of the set. Obviously without any real data to go on, it’s difficult to build this into a model, but at the very least it does look innovative. It seems like something I would have liked if I was a kid. More importantly, it’s been totally discounted by the market and at this point represents little more than a free call option.

I believe that part of the reason Skylanders has been so discounted is that it doesn’t target ATVI’s typical audience, and Skylanders’ audience is perhaps assumed to be smaller or less willing to spend on games. Looking at the list of top selling games of all-time, this doesn’t make sense. Nintendogs, a pet simulation game, has sold more copies than Black Ops on Xbox and PS3 combined. The Skylanders target market is viable.

Valuation

The most important parts of my model have been described above. To value ATVI I’ve built a scenario matrix. I assume that Warcraft can either be flat, down 7%, or down 15% per year. I assume that Activision (CoD) will either be flat, up 10%, or up 20%. For reference, 20% growth is conservative compared to ATVI’s expected console growth rate. Growing sales at the installed base growth rate should be a baseline target for management:

I assume excess cash is used to repurchase shares. Most income statement and balance sheet items grow as a function of revenue. I value the company in 2015 and discount that valuation back to 2012 at 15% annually. My ending earnings multiple is a function of 2015 growth rates, ranging from 6x in the worst case scenario to 14.5x in the best case scenario. The results look like this:

Compared to LTM EPS of $0.84, the valuations above are based off 2015 EPS numbers that look like this:

The matrix indicates that ATVI is probably close to fairly valued assuming modest growth for Activision. But what’s most surprising is the range of values my model produces. This fact coupled with the low price of options means that calls could be an attractive alternative to shares. It’s also surprising to see how much more sensitive the business is to the CoD franchise than to Warcraft. Warcraft can move the needle a few dollars in each direction, Activision can halve or double the stock. Despite Warcraft’s importance to the bottom line today, Blizzard has a clear pipeline of titles and expansion packs to hold investors (and gamers) over until Titan. Also, because we’re looking 5 years out, the compounding growth of Activision easily outweighs Warcraft. My back of the envelope calculations indicated that Warcraft revenue declines would be traumatic, so I’m glad to see that ATVI can weather the storm with respectable growth in the CoD and other Activision titles.

If I decrease my discount rate to 10% rather than the standard 15%, my valuation obviously increases dramatically, not least because this results in a higher ending multiple ranging from 6x to 30x. (Demanding a lower return on investment means I’m willing to pay more for growth):

This set of assumptions is probably more relevant if we’re trying to guess future share prices, and it shows that ATVI is undervalued even with modest CoD sales and major declines in Warcraft.

Options

The real play here, in my opinion, is on the option side rather than the stock side. The January 2012 calls at $12.50 cost $0.45 for an Implied volatility of 35%. That seems cheap given that my model conservatively estimates shares are worth north of $20 if Activision can sustain 20% growth despite 15% declines in Warcraft. With the installed base of consoles up 20% and pre-orders of CoD are up over 100% YoY, that target shouldn’t be too hard to reach. January 2013 calls at $12.50 cost $1.15. Both of these expirations have substantial open interest, especially compared to other strike prices and expirations, indicating that I’m not the only person thinking this could be an interesting trade.

Part of the reason the implied volatility is so low is that Actvision has traded within a narrow range for a few years. I believe this is due in part to declining sales from Guitar Hero and the Tony Hawk skateboarding franchises, of which both have been fully worked out with no remaining liability. Nothing else filled that void, and so the real risks of decline come from overestimating CoD or underestimating declines in Warcraft. This chart from Bloomberg compares IV to the share price:

At historically low implied volatility with enormous fundamental reasons to expect volatility in the future, options are a better play than shares. To be clear on how cheap these options are, I’ll walk through an example. Buying enough January 2012 $12.50 options to exercise a portfolio into a 10% position would only cost 0.4% of the portfolio. If the stock closes at $15, the entire portfolio would be up 2.25%. The asymmetry is huge, and even a nominal position can have a significant impact. A $15 guess compares to a $16 price target set by Citi on September 6th, 2011.

Apple is undervalued primarily because it’s now the largest publically traded company in the world. Investors believe that there is some limit to its size, and our thinking has been anchored to the size of Exxon Mobile. I believe that as Apple overcomes the “biggest company in the world” speed bump, its market cap will unhinge from the $350 billion limit imposed by XOM and explode up to a more realistic valuation. This will be fueled by strong earnings growth for the numerous reasons discussed below. Furthermore, because the stock has been trading within a fairly narrow range since January, volatility has been low. As a result, options are also undervalued for technical reasons (ATM IV at 35%), making calls an attractive way to get more leverage on the investment thesis.

Power Law

Before we start looking at actual growth rates, I want to make one quick effort to debunk the “too big to win” myth. The Power Law is a well-documented phenomenon in mathematics, more commonly known as the “80/20 rule”. We can estimate that 80% of web traffic is driven by 20% of websites, 80% of the population lives in 20% of our cities. We find this phenomenon everywhere, both in nature and in man made systems. When we plot these distributions, they look like this example chart from Wikipedia:

Likewise, it shouldn’t be surprising that 80% of profits are earned by 20% of our companies. Plotting the largest companies based on market cap should look like the example of a power-law distribution above. Here is what the distribution looks like for the top 50 companies:

If Apple traded at 25x trailing earnings, a totally reasonable valuation, the chart would look like this:

This isn’t unimaginable to me. It perfectly follows the well-known power law and is natural. To some degree it more accurately reflects reality because Apple is undervalued. The current valuation of Apple has been arbitrarily limited by the market cap of an unrelated company in an unrelated industry simply due to size. This is a common psychological impediment to rational decision-making known as anchoring.

However, these charts prove nothing. All I intended to show was that Apple could expand its valuation without crushing our understanding of economics or the natural order of the universe.

A low-growth scenario is insane

The fact that Apple is a large company does not mean that it cannot grow. I’m not saying that growth prospects are limitless, and I’m not advocating that we simply extrapolate historic growth rates into the future. We need to think about Apple’s growth prospects by understanding its product line and the competitive landscape.

The following chart shows how Apple has generated its revenue for the past few quarters:

Obviously the most important component is the iPhone, a product that barely existed two years ago, followed by the iPad, a product that didn’t exist two years ago. Because of how much growth has been fueled by innovative new products, investors seem to get stuck trying to figure out what the next new product will be. Opportunities exist, and I’ll discuss this at the end. But more importantly, existing products have ample room for growth, and can more than justify a higher valuation. To start, I’ll focus on the iPhone and iPad segments individually, add in some thoughts on the other segments collectively, and then discuss China and some obvious avenues for continued innovation.

iPhone

The iPhone has been the biggest driver of growth for Apple in recent quarters. Fortunately, the nice folks at Garnter make forecasting easy for us. For starters, they have summarized current market share data. The following two charts from Gartner show Apple’s share of cellphone sales, and the iOS (Apple’s operating system) share of smartphone sales:

We can see that Apple has doubled iPhone sales and increased market share. Also important to note is that market share is still small, indicating that Apple has ample room to run. But this is history, not relevant to current or future Apple shareholders. Fortunately Gartner has also put together some forecasts for us:

Unit sale increases to 190k units in 2015 represents a CAGR of 20.3% over 2011 unit sales of 91k units. Assuming revenue per unit stays flat, this alone translates into 9.1% revenue growth for Apple (when mixed in with all of Apple’s other products). In 2012 alone, forecast unit sales of 119 million represents 71.4% growth over the LTM unit sales of 69 million. This alone translates into Apple top-line growth of 32.0% in 18 months.

This leaves two questions. A) how will revenue per unit change, and B) why is market share declining to 17.2%? Gartner answers both questions with this paragraph:

Gartner predicts that Apple’s iOS will remain the second biggest platform worldwide through 2014 despite its share decreasing slightly after 2011. This reflects Gartner’s underlying assumption that Apple will be interested in maintaining margins rather than pursuing market share by changing its pricing strategy. This will continue to limit adoption in emerging regions. iOS share will peak in 2011, with volume growth well above the market average. This is driven by increased channel reach in key mature markets like the U.S. and Western Europe.

So the forecasts above assume that Apple effectively prices itself out of the market, to some degree, to maintain margins. Why these high prices weren’t a deterrent in recent quarters, I don’t know. Sales in “Asia-Pacific” (ie China) grew by 160% in 2010 and 191% in the first nine months of this year. (These growth rates aren’t specifically for iPhones.) China has a low GDP, and yet consumers are gobbling up Apple goods. If Apple’s pricing strategy “continues to limit adoption in emerging markets” to a sub-200% annual growth rate, investors won’t have much to complain about.

But this growth rate provided by Gartner assumes that Apple’s strategy department doesn’t understand basic economics. Apple generally sells its goods at higher price points than competitors, and I don’t expect this to change. But Apple does not limit its offering to one product at the highest price point. iPods range in price from the Shuffle starting at $49 to the Touch topping out at $399. Computers range from the Mini starting at $599 to the Pro with a top-line model starting at $4,999. Offering one phone at the maximum price point is not a strategy Apple is likely to stick with for its top selling product. This assumption is absurd. So the Gartner forecasts, in my opinion, are really a worst-case scenario and present only a baseline growth rate. Apple clearly has opportunities to continue growing market share in a rapidly growing industry while maintaining margins, and even high price point products are selling in low GDP countries.

Furthermore, I agree and fully comprehend that smart phone prices (as well as PC prices) will generally decline over the long-term. The questions are to what degree will price cuts increase demand and to what degree will component manufacturers take a hit. Modeling this relationship in detail is unlikely to yield an information advantage. But Apple is the market player with the greatest bargaining power with suppliers and the greatest pricing power with consumers. This gives Apple the best protection against shrinking margins and the most opportunity to benefit from growing market size, a recipe for success. Apple is not going to be the one to suffer from this long-term trend.

To summarize, a pessimistic forecast for iPhone growth through 2012 alone is enough to justify analyst estimates for EPS growth. Less pessimistic forecasts are easy to conjure, and Apple has other products that are performing well. And there isn’t one year of growth left, growth is forecast to continue at least till 2015.

iPad

The next most relevant product for Apple is the iPad, a product that’s been on the market for just over a year. Credit Suisse estimates 2011 Apple sales of 41.2 million units, compared to 25.5 million in the LTM and 65 million units to be sold industry wide. 2012 sales are forecast at 59.2 million units compared to 116 million units for the industry. Credit Suisse derives these estimates by looking at the distribution of average sales prices for desktop and laptop computers over the past decade, taking note of how prices have dropped, and then working tablet cannibalization into the price point model. Overall this assumes 16% unit growth globally. In 2012, tablet sales are forecast to represent 23% of sales, the vast majority of which will be replacing laptops in the $300-$699 range. In the short-term, these estimates seem reasonable. Credit Suisse models out to 2015, eventually concluding that tablets will represent 42% of PC sales. I intuitively suspect these estimates are too aggressive. But 2012 forecasts for 59.2 million unit sales compared to 25.5 million in the LTM represents 132.2% growth. Growth in the iPad segment should therefore contribute an additional 27.5% of revenue growth for Apple. Adding this to our iPhone sales growth from above, and we’re at 53.4% revenue growth within 18 months.

These forecasts are again conservative compared to Gartner’s forecast of 69 million unit sales for Apple in 2012, an incremental improvement of 16.6%:

The Gartner forecasts represent a 69.0% CAGR from 2011 to 2015 just for Apple. I’ve been focusing on 2012, but this obviously represents sustainable growth well beyond the next year, and it’s a good supplement to iPhone growth.

Computers

Part of what makes the iPad so important is its enterprise adoption. It took a few years before businesses were using iPhones. iPads were adopted immediately and in large scale.

If iPads continue to be adopted by businesses, it stands to reason that corporations might eventually begin to adopt other Apple products as well. As this report is being written on a MacBook Pro by someone who does not own an iPhone, iPod, or iPad, I’m admittedly at a loss to explain why computer adoption hasn’t already occurred. Apple computers are easy to use, difficult to break or crash, and secure. I suspect that iPad adoption may be the catalyst to increased Mac use as users become familiar with the operating system, accustomed to the stability, and eventually hooked on the cloud based services that synchronize devices together. If that doesn’t convert users to Mac, a devastating global computer virus eventually will.

I said before that I don’t want to rely on extrapolating trends, but I think in the case of computer sales, historic growth rates provide the fairest estimate of future growth rates. Also, unless Mac sales grow tremendously, sales are almost immaterial compared to the iPhone and iPad. This doesn’t make or break the investment thesis. The chart below shows how computer sales have changed since 2005:

Assuming these growth rates hold steady for another year, we can predict sales growth of just under $5 billion, or an additional 4.9% revenue growth, bringing our total to 58.3% growth in 2012.

iTunes and iPod

I’m labeling “other music related products and services” as iTunes, because that’s effectively what it is, and looking at it alongside the iPod. The same chart above reproduced for these two segments looks like this:

Assuming that iPod sales stay flat and that iTunes continues to grow at its historic rate, these two segments add another 1.3% growth to the top line in 2012, bringing our total growth to 59.6% using conservative forecasts. Assuming Gartner forecasts for iPhone and iPad sales are correct, Mac and iTunes continue to grow at historical rates, and iPod and other revenues stay flat, Apple will generate $225 billion of revenue in CY2015, compared to $100 billion in the LTM.

Additional Upside

If 58.3% growth in 2012 materializes, we’re paying 6.9x earnings and 4.2x EV/EBIT (assuming the cash balance doesn’t increase) in 18 months. This seems like a good deal for a company that has dominated its markets. But of course, if we’re then stuck at some lower growth rate beyond 2012, maybe in the 10% range, investors might not be happy and a 7x earnings multiple may seem justifiable. But in the most likely scenarios, growth should continue at a respectable rate at least until 2015 given the strength of Apple’s position. Furthermore, there are clear avenues for Apple to continue innovating and growing.

The biggest opportunity for Apple is to take advantage of its popularity in emerging markets where Apple products are a status symbol. Carrying around an iPhone is a visible sign of wealth, but not something that can be easily copied like a fashion accessory. In the most recent conference call, Tim Cook states:

China was very key to our results. As a reminder, for Greater -- we define Greater China as Mainland China, Hong Kong and Taiwan. Year-over-year it was up over 6 times. And the revenue was approximately $3.8 billion during the quarter, and that makes the year-to-date numbers through the three quarters that we have had thus far around $8.8 billion.

This is party attributed to a retail store presence (although retail sales are counted separately). Apple has stores in the US, UK, Canada, Australia, France, Japan, Germany, Italy, Switzerland, Spain, and China. China is scheduled for the most store openings, but surprisingly it’s the only emerging market location on the list. Both based on GDP and GDP per capita, other countries not on the list seem ripe for store openings. And the lack of capital is obviously not a problem. Expansion to Brazil, Russia, China, Singapore, the UAE, and Hong Kong all seem like a great idea, if for no reason other than to introduce new products to large markets. Other countries are similarly underserved. This isn’t a company that’s nearing saturation, it’s barely scratched the surface.

Aside from the geographic opportunities, technological growth opportunities still exist as well. The two in particular that I find interesting are television and video games. Rumors of an Apple television with iOS installed have been circulating quite a bit, and the concept makes sense. Apple TV has been out for a while, but as a stand-alone streaming content box, it hasn’t done too well. Integrated into a set, it might be a more attractive offering. Another thing that hasn’t done well is $0.99 single TV episode rentals on iTunes. This service was pulled from iTunes recently, in a move that might have surprised some. Perhaps it will be more profitably reintroduced in an integrated hardware offering? The Times summed it up nicely saying:

The slight retreat by Apple comes two days after Tim Cook was named the chief executive of Apple, replacing Steve Jobs, who was named chairman. And it comes at a time when the company is widely believed to have its industry-disrupting sights set on the television industry.

In the meantime, Apple has decided to move towards a cloud-based ownership model. As iTunes in conjunction with iPod was disruptive to the music industry, it’s easy to see how iTunes in conjunction with an Apple TV and some new pricing schemes could be highly disruptive to the broadcasting and network businesses, which have relied on bundling for so long. A-la-carte packaging options transmitted over broadband will appear attractive to many consumers, and as the distribution model matures, it may become more attractive to the likes of HBO and other content producers. A recent report from the Economist states:

In future HBO Go could allow the network to bypass the entire pay-TV system. For now, going “over the top” in this way makes no sense, says Bill Nelson, HBO’s chief executive. There are roughly 105m multichannel TV households in America, of which 77m do not subscribe to HBO. By contrast, he reckons, there are only about 3m households with broadband connections and reasonable amounts of money but no multichannel TV. It makes sense to go after the bigger group. But this may change. “Let’s assume that in ten years’ time there has been a significant shift away from multichannel subscriptions,” says Mr Nelson. “In that environment, HBO may reconsider its position.” If HBO were to try selling its programmes directly via the internet it would have a hugely disruptive effect on the television business—more disruptive than anything Netflix or any other company has yet done.

Apple could also enter the video game market. Buying Nintendo would be a quick shortcut to success, picking up a handful of the most successful franchises of all time, and on the cheap. Nintendo currently trades 2.7x trailing earnings, or $2.7 billion. This is because recent product launches have been failures. While Nintendo’s president has claimed that he doesn’t want to produce games for iOS, the fact of the matter is that Apple already has the functionality using Apple TV that the Wii U (Nintendo’s next system) will have. On the heels of a failing 3DS, Nintendo is launching its next major equipment upgrade into the headwinds of a competing Apple product already in the market for $99. The fact of the matter is that Apple is getting into games, even if not deliberately. Nintendo can defy shareholders for a while, but not forever. And from Apple’s point of view, the IP must be attractive, especially at the current trading price of Nintendo shares. And on September 6th, news surfaced that Apple products would be sold at GameStop…

In both TV and games, Apple could be characteristically disruptive. These two strategies could be combined, with iOS natively running Nintendo games. iTunes would also further benefit from TV content subscriptions, episode downloads, and digital game sales. But most importantly, this is all gravy on top of iPhone and iPad sales, which more than justify Apple’s current share price.

The Disconnect

Ignoring all these upside opportunities, how does my model compare to the sell-side? Here is my revenue forecast based almost entirely off of Garnter forecasts:

And this is a revenue forecast from FBR Securities:

2012 total revenue is expected to be $126 billion with $60 and $24 billion coming from iPhone and iPad respectively. My revenue lines should be a bit higher as I’m using the calendar year compared to Apple’s fiscal year ending in September. But one extra quarter of growth doesn’t explain the huge difference with disparities across the board (but most apparent in the iPhone and iPad segments). Unfortunately the report doesn’t really dig into the iPhone market, but it does cite iPad unit sales of 50.9 million units compared to Gartner’s estimate of 68.7 million. At 50.6 million units, FBR is assuming an iPad ASP of $468 compared to $640 in the LTM. The reason for this decrease isn’t made clear, but FBR does reference the Gartner forecasts, and it should be noted that while estimates are lower than Gartner in 2012, they are higher in 2013, so Gartner (and I) seem to be front-loading sales a bit more.

While FBR doesn’t state iPhone unit sales expectations, they do say that market share should decrease from 53% to 50% in 2012, citing the Gartner expectations that a lower-priced phone won’t be released. They leave room for upside if a $200 phone is offered.

Furthermore, this report was published in June 2011, and it was predicting 2011 EPS of $12.93 and $14.39 in 2012. Apple has already reported $25 in the LTM and analysts are now expecting $27 at the fiscal year end. Only 3 months out and this report’s estimates are already antiquated.

Here is the revenue summary from a Credit Suisse report:

Again in 2012 my forecasts are too high with the focus on the iPhone and iPad. Credit Suisse is a little more explicit, stating 112.2 million iPhone unit sales compared to my 118.8 (which can be explained by my extra quarter), and 59.2 million iPad sales compared to my 68.7 million estimate (which probably can’t be explained by an extra quarter). However, these estimates resulted in much lower revenue. Credit Suisse estimates revenue per iPhone unit to be $601 compared to $648 in the LTM, and revenue per iPad to be $578 compared to $640 in the LTM. So perhaps my assumption that ASPs won’t decline in the next 18 months was an aggressive one.

On September 6, Credit Suisse released an updated guidance with iPhone sales in FY2012 of 118 units, the same as the Gartner estimate for the calendar year. It looks like estimates are moving in the right direction.

How well have analysts in general predicted AAPL performance in the past? This chart from Bloomberg shows analyst EPS forecasts and how they change on quarterly basis:

We see from this that analysts have underestimated Apple earnings growth significantly every year. This isn’t surprising, no one could have predicted the iPad’s success, and the iPhone’s success was surprisingly strong as well. That being said, despite the fact that I’m predicting higher revenue in 2012 and the same gross margins as analysts, I’m also assuming higher R&D and SG&A costs, which results in 2012 EPS of $32.62. This is exactly in line with analyst expectations. My model isn’t wacky, and it predicts that shares could be worth north of $1,000 per share if investors are willing to pay 20x 2015 earnings. And this is based only on the projected success of existing products.

Options

Aside from the Apple is “too big to win” argument, I haven’t seen any reason to be pessimistic about Apple. If there weren’t clear paths to greater profitability, I would probably agree with the “too big to win” argument, but the evidence that Apple will continue to grow is overwhelming. It’s well positioned technologically, it has obvious economies of scale, tremendous love from consumers that translate into fat margins, and clear avenues for continued innovation.

Perhaps because share price appreciation has slowed as Apple’s market cap approached the market cap of Exxon Mobile, volatility over the past nine months has been low. This appears to have made options cheap. This chart from Bloomberg shows Apple’s share price and the implied volatility of at-the-money options:

Two possible scenarios exist for the next twelve months. The first is that investors will continue to fret about the “to big to win” argument and shares will continue to trade at low multiples in the 10-15x range, but the company will continue to perform well and will therefore continue to grow its share price by 30-50% annually. The second scenario is that continued growth will push the market cap up to $400 billion, investors will see that Exxon Mobil was and will continue to be irrelevant, and then the share’s will unhinge from the XOM valuation and reset to a reasonable price, probably in the $600-$700 range.

In the first scenario, 30% growth and a 15x earnings multiple at year-end 2012 would translate into a share price of $520. January 2013 stock options at an exercise price of $400 cost $65 today. This would generate an 85% return. In scenario two, the share price more accurately reflects reality and Apple trades up to $700, yielding a 362% return. The options market is simply not factoring in the probability of strong growth for fundamental reasons.

Downside scenarios exist, although I’m having trouble imagining them. Under new leadership, it’s possible that Apple could release a string of junk products. However, even if Steve Jobs was the secret sauce at Apple, he’s still involved in the business, just not running the day-to-day operations. And Apple has released its fair share of flops in the past, it’s just quickly forgotten. A string of bad products seems like a concern investors might face beyond 2015.

It’s also possible that an economic downturn can disrupt Apple. On the upside, at least there isn’t much liquidity risk on this one. The affects of a global recession are difficult to predict, and the impact on Apple’s share price is even more difficult to predict. But call options limit downside risk while maintaining significant upside as long as position sizes are kept reasonable. This should be an easy trade to get comfortable with.

08/12/2010

GSL is one of my favorite ideas, it's performed well since I wrote it up, but it still has a lot more room to run. The risk-return ratio is arguably better than it's ever been before.

The major risk used to be a default by CMA CGM. With only one customer, a default by GMA CGM would have been a default for GSL. However, we can see from the chart below comparing GSL shares to CMA CGM debt, that GSL has only recovered a fraction of its value compared to the recovery in CMA CGM debt:

08/09/2010

AerCap Holdings (AER) is a large airplane lessor trading at an attractive valuation both in an absolute sense and relative to its peers. The most likely reason for this mis-valuation is the fact that AER has separated itself from its comparables by significantly increasing the size of its fleet through the downturn and the benefits of this haven’t worked through the financials yet. In the first quarter, flight assets were up 71% versus a year ago, part of which was the result of a large acquisition paid for with shares. But even after accounting for share dilution, book value per share has tripled in the last 4.5 years. The strategy to opportunistically make large acquisitions counter-cyclically is paying dividends as utilization rates have remained high and credit lines secured by the company have locked-in ample capital for growth at low interest rates. With variable (but capped) interest rates, AER is currently benefiting from an unusually low cost of capital. But with caps in place, the model isn’t terribly sensitive to adverse changes in interest. The income statement is also boosted by non-recurring profits from the sale of planes. But even after making the necessary adjustments to account for lower sales revenue and higher interest rates, AER should still deliver an equity yield of 15% or more, and it has attractive opportunities for reinvestment and growth. Purely on a valuation basis, this compares favorably to its competitors which were not able to grow through the weak economy, which have older fleets, and which in general have displayed weaker operating metrics. For example, AER has higher asset turnover (lease revenue over assets) than its peers and it’s able to trade assets out of its portfolio at a profit. I have a tremendous amount of faith in AerCap’s management team, but with shares trading at a discount to book, and the book value appraised at a discount to market value, current investors aren’t paying a premium for good management.

Rough Valuation

A rough estimate of forward earnings can be produced using the current book vale of PP&E and the net spread over assets metric. Management calculates net spread as basic lease rents minus interest expense over PP&E. Note that “basic rents” is lease revenue excluding maintenance rents and end of lease compensation. Net spread is of course dependent on a number of factors including interest rates, leverage, and depreciation rates (not because depreciation is taken out of the spread but because it affects asset values), but for the most part this metric seems to hold fairly steady over time. Historically, AER has achieved net spreads ranging from 7.5-9.7%, comparing favorably to approximately 7-9% for AYR and FLY. But there is one reason why this calculation might handicap AER. AER has grown assets at a much faster rate than AYR or FLY, and since I’m using end of year assets in my calculation, the full benefit of acquiring those assets will not be reflected in the financial statements.

If asset turnover remains at 12.6%, as it has historically, the leasing business has $960mm of current annual revenue generating power off a current asset base of $7.625 billion. $960mm in revenue lines AER up to hit a 9.2% net spread, just below the target management has set for the year. This compares to basic lease rents of $229 earned in the second quarter, annualized out to $914mm, but keep in mind flight equipment (planes) grew from $7.198B at March 31 to $7.625 by June. If $960 is reasonable, the income statement should resemble the following:

*SG&A: $140 – High end of mgmt estimate for 2010-2013*Lease Expense: $82 – High end of mgmt estimate for 2010-2013D&A: $343 – 4.5% of PP&E. 4% is more likely accurateEBIT: $395* higher than annualized Q2 expenses

Based on this very basic analysis, it already looks like AER is fairly valued for a company that continues to execute well and grow, but we’re excluding some major components. Given that analyst estimates for 2010 have AER generating $1,629mm of revenue, $898 EBITDA, and $1.92 EPS, we know we’ve missed something. So let’s build upon what we already have.

For starters, this analysis excludes maintenance revenues, estimated by management at $65mm/year and management fees of approximately $10-15mm. The costs associated with this operation have already been included in the SG&A expense line. We’re also excluding the AeroTurbine business, effectively an engine chop-shop, which has grown EBITDA from $21.6mm in 2006 to $52.9mm in 2009. We’ll just assume that this low-capital, rapidly growing business will not continue to grow, and that EBITDA represents a stable cash flow to shareholders. Management is expecting AeroTurbine to bring in $200mm of revenue, so we’ll feed that into the top line of our model as well, and make up the difference between that and EBITDA with CoGS. Now the business looks like this:

It still seems like my revenue, EBITDA, and EPS estimates are a bit low, but we also have to consider the sale of planes out of the existing fleet. Management claims that an appraisal of their planes would value the fleet at approximately an 11% premium to the book value. They have consistently demonstrated that this is likely true by opportunistically selling planes out of the portfolio at a premium to the book value, allowing them to book a profit.

We certainly don’t want to make the mistake of simply applying a normal earnings multiple to this piece of the business unless we’re confident it’s sustainable. To estimate the valuation, we really need to better understand why/how AerCap is able to continually sell planes at a premium to book. There are three possible reasons. One is that they got lucky and either found distressed sellers or anxious buyers and this income is really one-off in nature. The fact that AER has generated significant sales profits every year makes this unlikely. Another possibility can be accelerated depreciation, in which case the sale of planes at real market prices would really just represent AER management reclaiming the book value lost to conservative accounting. Also not the case as AER is selling some of its planes at a profit before they’re even delivered. The final explanation is that they do a good job of understanding the market, understanding valuations, and they opportunistically buy and sell when market values are a bit wacky. Now I know the initial reaction to this statement will be doubt that the market for planes can be inefficient, but I urge readers to consider their chosen professions as a case in point. Good trading seems to me to be the most plausible explanation, and based on the current valuation, we don’t appear to be paying much for it.

Returning to the income statement, management expects sales revenue (excluding AeroTurbine) of $600mm in 2010 and $200mm thereafter. At a below-average margin of 15%, this would boost EBIT by $90mm in 2010 and $30 somewhat continuously thereafter. $200mm compared to the current book value is a portfolio churn of less than 2.6%. Not unreasonable. An extra $27mm (after tax) per year leaves us with the following, indicating to me that the stock has ample room for 100% upside:

Net Income: $240Shares: 119mmEPS: $2.02P/E: 6.4x

Just to clarify, I don’t know that this piece of the business will actually be recurring. Even if it is, it will likely be lumpy. However, we don’t need this piece for the investment idea to make sense. Investors should focus on the 7.3x earning they’re paying, and think of this sales piece as a potential bonus.

90% of what I’ve done is based on management forecasts. To some degree, it coincides with analysts, but more importantly it coincides with historic performance. Comparable companies AYR and FLY are trading at 9.2x and 10.3x 2010 estimates (from Bloomberg) respectively.

Caveats

One way to explain what I see as a potential misvaluation is to consider the fact that AER is more leveraged than its competitors. If we consider an EV (including minority interest) to basic lease rent ratio, AYR and FLY are trading at about 6x whereas AER is trading around 8.5x. Using the EBITDA number estimated above (excluding the sales piece) AER is trading at around 9.1x EV/EBITDA compared to 6.1 and 7.8x for AYR and FLY respectively. Factoring the D&A back in, we can estimate a cap rate of 6.7%, 9.7%, and 7.2% for AER, AYR, and FLY respectively. One could easily make the argument based off this that AYR is the most undervalued. If this was a chapter 11 situation, I would agree. Or if I believed that AYR or FLY would draw on that “available capital” to fuel future growth, I might change my mind. But AER appears to have maintained the most consistent capital structure, shareholders benefit from the growth opportunities it affords, and current debt levels don’t appear unsustainable. More importantly, I appreciate management’s willingness to grow the balance sheet when asset prices are depressed. If AYR and FLY decided to lever-up and grow the business, they might have already missed the prime buying opportunity that AER capitalized on. Shareholders should benefit from this, even if AER spends some time deleveraging in the coming years.

There are other risks as well. For example rising interest rates could pressure the bottom line, but even that increases costs for airlines looking to finance their own purchases, so to a large extent financing costs are externalized. The trick is to match liabilities to assets in terms of duration and exposure to floating interest rates, which AER seems to have done a good job of. That job will get easier as the securitization market recovers, and it’s entirely possible that AER will be able to securitize a large pool of assets locking in attractive 30 year financing. Falling fuel costs could also be a risk to AER as most of their planes are newer and more efficient. Falling fuel costs would bring excess idled capacity back into the market and potentially make newer planes less economically justifiable. However, these costs are passed on to passengers (and shippers), meaning that falling fuel prices will increase demand and increase the volume of traffic. Again it seems like negative feedback loops stabilize the leasing business model.

So in conclusion, it seems like AerCap has performed well and the share price is attractive. Naturally there’s quite a bit of leverage at work here, so minor variations in my assumptions can have a significant impact on the bottom line. I’ve been careful, but obviously readers will have to work through the numbers and financial statements on their own.

06/02/2010

Basic prospect theory is something
that every professional in finance should be familiar with.At the very least, if you don’t find it
interesting, you’ve chosen the wrong career.The main claim is that our willingness to assume risk changes depending on
the scenario.For example, when given a
choice between a free $25 or a 50/50 chance to win $60 or $0 the optimal choice
is to take the coin flip with an expected payout of $30.But many people will choose the safe $25.You probably find yourself agreeing with the
$25 decision and you right now, and you might think I’m nuts.We call this “risk aversion”. But put into a context where the player can
play this game multiple times, she’s more likely to take the risk.Over the course of a lifetime, these
seemingly unique opportunities will
present themselves multiple times, and avoiding these good bets can take its toll.

Counter-intuitively, when faced
with the decision between a free $25 or a one-in-a-million chance of winning $5
million (the expected outcome of which is only $5), many people will choose the
lottery ticket.Not me (I hope).

Even more counter-intuitively, when
people are facing risk in the realm of losses, we tend to be risk seeking.For example, given a choice between paying a $25 ticket, or fighting the
ticket with a 50% chance of paying nothing or a 50% chance of paying a fine and
legal fees totaling $100, the best choice is to just swallow the $25 loss.The expected outcome of fighting the ticket
is a loss of $50.But many people will
foolishly roll the dice.

These preferences, despite being
sub-optimal, are well documented by behavioral economists.Every year we’re discovering new ways in
which people systematically make poor decisions.

I believe this disparity exists because the short-term nominal yield on TIPS is negative.The chart below shows the yield on 2-year
TIPS (in green) is a negative 0.5%.The thought of
locking in a loss is undoubtedly distasteful to investors, despite the fact
that individuals holding treasuries, CD’s or even cash are likely going to
experience a loss of purchasing power anyway.

According to prospect theory, because we’re dealing with
locking in a loss, we’re in risk-seeking
territory.Investors fearing runaway
inflation will avoid TIPS, which guarantees a loss, in favor of alternative
inflation hedges that might not protect against inflation as well and might
bear significant risk of loss, but which optimistically might result in no loss
at all or even a gain!

So the questions become:

1)What
investments are you holding in your portfolio because of inflation fears, and
is there a better way of managing that inflation risk?

2)If
you fear 30% inflation over the next 5 years, doesn’t a 30% nominal yield on treasuries sound more attractive than
rolling the dice on some other “inflation hedge” that may or may not appreciate
in value and might result in significant losses?

3)Can
you reconcile the 2% inflation expectation implied by the TIPS spread with the
price you’re willing to pay for your “inflation hedge” (ie gold)?

05/20/2010

Novatel Wireless (NVTL) is a high quality tech company with
no debt trading at the value of cash plus investments (enterprise value turns
negative at $5.90/share).Since there’s
no chance of the company liquidating and it’s unlikely the company will make any
other cash distribution, I can understand why the market is ignoring the cash
value.But the company isn’t a dog.It’s grown revenue from $104mm in 2004 to
$337mm in 2009 while only increasing share count from 29mm to 31mm.Evidently they’re investing in valuable R&D.It’s difficult to determine how valuable the R&D is but we’ll
try and establish a range by capitalizing R&D and amortizing it at various
rates to estimate RoIC.If NVTL
continues to plow earnings into R&D, they might never show a profit, but
that doesn’t mean the business won’t grow, in both size and value.And even if we assume that R&D is
effectively a sunk cost, FCF has been significantly positive at $31mm, $17mm,
and $34mm in 2009, 2008, and 2007 respectively.Novatel is profitable and should trade at a higher enterprise value than
zero.

The Business

Novatel competes in three primary segments, but the MiFi
product is arguably the most important (47% of Q1 sales).Other segments include USB and data card
modems (50% of Q1 sales) and embedded wireless connectivity devices (3% of Q1
sales).

The MiFi is effectively a cell phone that creates a WiFi
bubble around itself, providing up to five nearby devices with internet
access.With very positive initial
reviews, a good job by the marketing team on branding, and expected increases
in data transmission over wireless networks, initial analyst estimates were
optimistic.But every quarter, sales
seem to disappoint.Initially, it seemed
like the dynamics of sell-through vs sell-in were to blame.Now the upgrade cycle is a problem (expected
to resolve in the second half as we transition from 3G to 4G).But there is one other problem that isn’t
being spoken about by analysts.The MiFi
is being sold by 18 wireless carriers worldwide.You can see which carriers are involved and
how geographically diverse they are in the map below:

But it’s difficult to reconcile this map with the fact that
92% of revenue came from North America in Q1.We can see in the chart below that despite
having $33.8mm of revenue from MiFi sales, only $5.6mm of revenue was
international:

The missing piece to the puzzle is that European telecoms
made a marketing error.In stores where
cell phones are typically given away for free or heavily subsidized, the MiFi
was sold as a retail product.Sales
never picked up.Here’s an article
discussing the different
marketing approaches.Now, that
marketing strategy is being reconsidered.We can see from the google trends chart below that internet searches for
MiFi are strong and likely growing stronger.This is aided by the fact that every quarter, NVTL announces new carrier
partners.

We can also see what country these searches were originated
in.The US and Canada are responsible for a
disproportionate share of revenue relative to internet buzz.I expect some of this buzz to translate into
sales in coming quarters as telecoms work out attractive pricing plans.

As difficult as it is to guess what MiFi sales will be, the
other products are even worse.Embedded
product (mini card) sales will always be lumpy.NVTL will constantly have to bid on and win deals in competitive markets
to sell mini cards, and the market seems to have all but dried up.The only guidance we have is an LTE (more
advanced technology) design win for a 2011 laptop model with tier-1 laptop
manufacturer.So we know this category
won’t go extinct, but it’s hard to estimate what contribution it will make,
especially short-term.

The wireless modem business has also been on the decline for
a while as competitors have squeezed margins.Some of this business will fall victim to cannibalization from the MiFi
business.The best I can do is relay
management’s sentiment from conference calls.The story is that we’re late in the 3G technology stage, so NVTL is
experiencing normal margin compression, and there should also be some pent-up
demand for new products once 4G rollouts start happening in the 2nd
half.I can’t translate that into a
forecast, and analysts who have tired before have failed.

Realizing how difficult it is to estimate future revenue,
the best way to value NVTL is to consider what has been spent on R&D in the
past, and what sort of a return this R&D has generated.I realize that it’s the future that matters,
not the past.But the simple fact of the
matter is that with at most an 18-month product cycle, NVTL will likely be
unrecognizable in three years.It will
be selling different products to different customers.But we know that NVTL has employees with
skills in research, design, marketing, and a management team with a track
record of selecting R&D projects.So
if we want to know what the future holds for Novatel, we need to consider its
past.

RoR&D

Estimating what sort of return Novatel generates on
investment in R&D is a challenge and requires judgement.This is compounded by the fact that NVTL
claims the product cycle has shortened (meaning R&D becomes obsolete
faster) from about 18 months three years ago to about 9 months today.The driver of obsolescence is the product
cycle.Multiple carriers in different
countries are operating their networks off two main technologies, EV-DO or
HSPA, continually upgrading their networks to provide faster data access.Competition is intensified as the boundary
between phone and TV networks is blurred.The EV-DO branch of the technology tree is in the transition to WiMax,
and HSPA is currently transitioning to the Dual Carrier brand of technology.The next step in the technological evolution
is LTE (short for “long term evolution”) which will be backwards compatible
with either EV-DO or HSPA, but should be compatible with each other, improving
the economics for R&D.Half the
research will address twice the market.

The future is inherently difficult to predict, but we do
have a nice record of what’s happened in the past.We can use the record to capitalize NVTL’s
R&D (move it from an income statement expense to a cash outflow from
investing), booking it as an asset, and then depreciating it at some rate.Readers interested in learning exactly what
this entails can read my tutorial here.Effectively what we’re saying when we expense
R&D is that it only benefits the current period.But R&D benefits more than just the current
period, equivalent to the way building a factory to produce widgets benefits
future periods.If we fully depreciated
a widget factory in the year we purchased it (ie expensed it), and then spent
our earnings every year expanding our widget factory, we would never report
earnings, but our profitable widget factory (and hence the value of our
company) would continue to grow.

What makes this analysis complicated is the fact that NVTL
does not generate a steady return on R&D.If they did, we would see a steady RoIC metric when we input the correct
depreciation rate.But we don’t.The purpose of this analysis isn’t to
pinpoint NVTL’s RoR&D, but rather to just get comfortable with the
mechanics of the business, and maybe to have a basis for comparison with some
other similar companies.We’ll start by
looking at the extreme scenarios and then work our way towards something more
reasonable.

Novatel’s financial statements already reflect one extreme
end of the R&D capitalization/amortization spectrum, the scenario where all
R&D is amortized in one year.This
isn’t totally un-analyzable.For
example, in 2005, NVTL generated $10.5mm EBIT off of $162mm of revenue after
spending $20.5mm on R&D.Because
they have no real assets, we have to assume that the only way NVTL was able to
generate revenue was from spending money on R&D.If $20.5mm was the investment and $10.5 was
the return, it generated a pre-tax 50% return.Using this math, we can calculate Novatel’s returns since 2002:

Unfortunately these numbers are lumpy.Instead what we can do is capitalized R&D
starting in 2002, meaning we’ll move the R&D expense line to cash flow from
investing, create a balance sheet asset, and then add an “R&D depreciation”
line back to the income statement to account for however much of this
intangible asset expires each year.I do
not believe the product cycle is (or will be) greater than two years, so we’ll
start by expensing 50% of the R&D asset each year.This generates the following pre-tax
RoR&D estimates:

These numbers are highly favorable, but of course they
ignore the other more tangible investments made by NVTL.If we look at an after-tax RoIC number, which
takes into account PP&E, goodwill & intangibles, and working capital,
we get RoIC numbers that look like this:

Not quite as impressive, but still respectable, and
deserving of more than zero enterprise value.Also keep in mind that NVTL only went public in 2001 and in 2002 it
generated 1/10 of the revenue it generates today.So those low return numbers in 2002-2003 should
be taken with a grain of salt.

Competition

Novatel competes in a tough environment.The fact that they lost a significant amount
of the traditional embedded business to Qualcomm and Ericsson, and the USB
modem business is being eroded by Huawei, is undeniable.But at the current market valuation, it’s
impossible to imagine fierce competition.If a larger company cared to compete with a product like the MiFi, it
would be far easier to just buy NVTL than reproduce the intangible assets.

Let’s say a company decided they wanted to reproduce the
MiFi.NVTL had R&D expenses of $45mm
in 2009, $35 in 2008, and $38 in 2007.If it cost just $80mm to reproduce the MiFi (R&D for the last two
years), a company should be willing to pay $8.82/share ($5.90/share in cash and
an $80mm EV).That would represent a 41%
premium to the current share price, and this ignores the value of customer
relationships, the value of patents which would have to be worked around (or
the cost of litigation), and most importantly the benefit of not having a
competitor in the MiFi space.There is
no reason why a company (not even a rinky-dink Chinese shop) would want to
compete in this space without simply acquiring NVTL.After rebates, the company is free.For investors worried about the difficulty of
a takeover, directors and named executive officers own 5.8% of the company and
the other 5% holders are giants. We don’t
need an investment banker to talk about synergies to realize Novatel makes an
attractive acquisition target.

Conclusion

No matter which way we slice it, it’s difficult to justify
the current valuation of Novatel.For
someone with enough money to buy the whole company, it’s free with management
included.For the average stock market
investor, we have to pay around $200mm for a company that’s generated average
FCF over the past three years of $27mm… still not a bad deal.This company will likely never report a
profit as they plow earnings back into R&D.But as long as they’re generating a reasonable return on R&D, as they
have, the business should continue to grow in size and value.The value of R&D is evidenced by strong
revenue growth.It might be difficult to
value, but not impossible, and with lots of cash, we have solid downside
protection.

03/16/2010

An interview I gave a few months back was used in a piece published at the Broker News Blog today. It's the final part of a very well written 6-part series on kaChing and other innovative startups in the financial services industry. Definitely worth reading if you want to learn more about what I do. Special thanks to Dan for a unique interview and a great write-up!

Shipmates

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